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A stochastic oscillator is a type of momentum indicator used in the technical analysis of security trading. Developed and advanced in the 1950s by Dr. George Lane at the E.F. Hutton & Co. brokerage firm, stochastic oscillators have since become one of the primary analysis tools used by securities traders worldwide. Useful for predicting turnarounds and reversals, stochastics are usually employed in conjunction with an arsenal of other tools at the technical trader's disposal, such as cycles, Fibonacci retracements, and Elliot Wave Theory.
According to George Lane himself, the basic concept behind the stochastic oscillator can be understood by visualizing a rocket going up into the air: "before it can turn down, it must slow down. Momentum always changes direction before price." Thus, stochastics measure the momentum of price. Because securities tend to trade within a certain range over time, the default setting for the stochastic oscillator is 14 periods, whether the periods be hours, days, weeks or months. By setting the oscillator for a certain past period, such as 14 days to the present, the user can then make a reasonable assumption as to the behavior of the market in the immediate future. Because of the tendency of some securities to trade erratically in the short term, the user should note that the oscillator smooths out the longer the set time frame.
The formula with which the stochastic oscillator is calculated is as follows: %K = 100[(C - L14)/(H14 - L14)]. In the formula, C represents the most recent closing price, L14 is the low price of the previous 14 sessions, and H14 is the highest-priced trade from that same 14-day period. A %D can be calculated by taking a 3-period moving average of %K. Chart representation is via two lines representing %K and %D, with a third line often used representing a simple moving average. Interpretation of the movements of lines %K and %D revolve around their convergence and divergence. By noting the patterns of crossover of the two lines, and in conjunction with other analysis tools, the chartist can make an informed decision as to market movement and take a bearish or bullish position as necessary.
The stochastic oscillator is also a good indicator to use when determining overbought and oversold levels. Known as a "bound oscillator," this indicator always operates within a range from 0 to 100. Traditionally, overbought and oversold levels are set at 80 and 20. When the security trades above 80 during its predetermined range, it is overbought, a bearish indication that may be the marker for a turnaround. Similarly, trading below 20 indicates an oversold condition that indicates that it may be time to buy. It must be noted, however, that these indicators must be used carefully, as a market on a strong downward or upward trend may not in fact be bearish or bullish, but indicate a more prolonged downward or upward spike.